Monday, 27 March 2017

What
does a devaluation in 1986 tell us about the likelihood of another devaluation
today?

Of all countries in
the Gulf, Oman carries the highest risk of devaluing its currency. Last year,
it ran a large current account deficit (roughly trade deficit plus remittances) of around 21% of GDP, a large budget deficit worth 12% of GDP, and
it has the lowest reserves among its neighbours. History shows that devaluation
is not impossible: Oman devalued its currency by 10% in 1986 when oil prices
collapsed. Why did Oman devalue its currency then? And what does that tells us
about the likelihood of devaluation today?

The fundamental
reason behind the 1986 devaluation was that Oman’s foreign currency reserves
were not sufficient. At the very least, a country should be able to back every
unit of currency in circulation with US dollars to maintain the peg, similar to
the gold standard. In 1985, just before the devaluation, Oman had $441
million dollars of reserves. And although there is no official money supply data going
back to the 1980s, I estimate currency in circulation to have been also around
$400 million in 1985. With the decline in oil prices in 1986, Oman had to use
its reserves to finance its deficit, which meant that it was no longer able to
provide dollar coverage for its currency in circulation and was therefore
forced to devalue.

Does Oman have
sufficient means today to avoid a similar devaluation?

·Oman’s reserves today are enough to
last the country for two years. Oman has $38 billion of reserves, which is more than
enough to back the $13 billion of Omani Rial currency and deposits. Moreover,
the remainder $25 billion of reserves could be used to finance two years of
external deficits (trade plus remittances), estimated to have reached $13
billion in 2016.

·Oman could also safely borrow from
international markets to finance the deficit for an additional year given its
low public debt ratio. Oman could still borrow around $13 billion while
keeping its public debt ratio relatively moderate at 30-40% of GDP. The
additional borrowing could finance its needs for one more year.

·The recovery in oil prices and support
from other Gulf countries could double the survival time of Oman. The recovery in
oil prices, which have bottomed out in 2016, will shrink Oman’s deficits and
financing needs. This means that the same amount of reserves and debt would
last the country longer. More importantly, other Gulf countries are likely to
step in to support Oman when needed to avoid the risk of contagion on their own
currencies. Indeed, recent reports suggest that Oman was in talks with Kuwait,
Qatar and Saudi Arabia to receive
a multi-billion dollar deposit. And although Omani
authorities subsequently denied the report, other Gulf
authorities have not. Interestingly, Oman
joined the Islamic Military Alliance, led by Saudi Arabia, around the same
time of the alleged talks.

Reserves, the
ability to raise debt, the expected recovery in oil prices and support from the
rest of the Gulf mean Oman could maintain the value of its currency for the next
5-6 years. There might be issues such as questions about the illiquidity of
reserves, the impact of a potential credit rating downgrade on Oman’s ability to
raise debt or concerns about political transition (although these
have abated lately). But all in all, a devaluation in Oman is unlikely
in the medium term.

Friday, 17 March 2017

The US central bank raised interest rates on Wednesday.
The
US economy is recovering: growth is picking up, unemployment is falling,
inflation is rising and the long overhang from the 2008 crisis may well be
behind us. This forced the central bank to raise rates to prevent the economy
from overheating and inflation from rising to uncomfortable levels.

Many central banks
in the region followed the US and raised rates. As their currencies
are pegged to the US dollar, many countries in the region were forced to follow
the US by raising rates. Absent this rate increase, capital would have
flown out of these countries into the US to benefit from higher rates, creating
pressure on the currencies and the peg.

Higher interest
rates would lead to slower growth in the region. Higher interest
rates reduce investments by increasing borrowing costs. Higher rates also lower
consumption by making saving become more attractive. Both of these factors should
lead to lower economic activity.

The fiscal position
could exacerbate the slowdown from higher interest rates. Due to lower oil
prices, many of the region’s governments are reliant on borrowing to finance
their deficits. But if borrowing costs rise, some governments may decide to
borrow less and cut their spending instead. Therefore, the fiscal response
could propagate the slowdown interest rate increases.

But the situation
highlights the region’s policy limitations. While the currency peg to the US
dollar makes sense from an economic view, it leaves government spending as the
main tool to manage the economy as interest rates are tied to their
counterparts in the US. But if government spending becomes responsive to
interest rates, then the region has no truly independent policy options to
manage the business cycle. This unfortunate situation came about because the
decline in oil prices coincided with higher growth and interest rates in the
US.

Sunday, 5 March 2017

The OPEC agreement
to cut production has shifted oil prices to a higher level, around $55 now
compared to $45 prior to the deal. But there are signs that higher oil prices are
leading to a revival in US shale production. Most energy market
forecasters expect increased US production in 2017 after a decline in 2016. Could
OPEC do anything to fend off the re-emergence of US shale? The short answer is
probably no. If OPEC decides to cut its production further, this will lead to a
loss in market share without any significant gain in prices. Conversely, the
benefits from flooding the market to increase OPEC’s market share are only
marginal and uncertain.

1. Further
production cuts by OPEC would be counterproductive. Further cuts would only
lead to temporary improvement in prices, as more and more shale companies would
become profitable leading to higher US production and a return of prices to pre-cut
levels. This means that OPEC would end up with lower oil revenues as it loses
market share without any gains in prices.

2. Despite increasing
its production aggressively in 2014-16, OPEC allowed shale an escape route. OPEC’s actions reduced
spot prices (the price at which oil is traded for immediate delivery),
but it did not reduce futures prices (the price at which oil is traded
for delivery in the future) below shale’s cost of production. The chart below
shows that a shale company with production cost of $50 per barrel was still
able to make profits in 2o15 by selling its output for delivery in 12 months’
time at the price of $55 in January 2015 and $51 in October 2015. Selling oil using
futures contracts allowed many shale firms to survive during the oil slump.

3. If OPEC floods
the market to reduce the spot as well futures prices of oil below the cost of US
shale, then the gains would be small. Although the gain in market share could more than compensate
OPEC for lower prices, the benefits are likely to be marginal. Even if we
assume that the new more aggressive market share strategy would be twice as
painful for shale as the one pursued in 2014-16, the overall increase in OPEC’s
revenues would be small, estimated to be around $12bn per year or less than 0.5%
of the cartel’s GDP. Furthermore, these gains would be quite uncertain given
the uncertainty about the reaction of shale and how their production costs
would evolve over time.

To summarise, OPEC’s
November cuts were successful because there was room for prices to rise before
hitting the cost of production of US shale, estimated to be around $50-55.
Now that prices are at that level, further cuts have little more to achieve. Flooding
the market on the other hand might seem more sensible, but back of the envelope
calculations suggest the benefits to OPEC are small and highly uncertain.

Sunday, 19 February 2017

OPEC’s
strategy has worked so far, but could end up being self-defeating.

OPEC surprised
markets on 30 November 2016 by agreeing
to cut oil production in an attempt to support prices. The cuts were meant to
reduce OPEC’s production by roughly one million barrels per day (mb/d), effective
from 1 January 2017. Data released in the last few days provide the first test
about whether the cuts have been successfully implemented. The bottom line is
that: compliance has been high helping prices to move up; the overall movement
was beneficial for the finances of OPEC members; but could prove to be short
lived as it gives a lifeline to US shale producers, who are likely to ramp up
production and depress prices. Below I elaborate on these points.

1. OPEC members have
complied with the agreed cuts. The latest data show that production fell to 32.1 mb/d,
lower than the 32.5 mb/d ceiling that had been agreed on. Every single country
reduced its production compared to October 2016 levels (see chart). Some have
made substantial reductions as in the case of Saudi Arabia, which lowered its
production by 598 kb/d.

2. The cuts have moved
oil prices to a new and higher range. While oil prices hovered around $45 per barrel before
the cuts, they have been fluctuating around $55 per barrel since the agreement.
This represents an increase of about 22%.

3. The cuts have so far benefited OPEC
finances as the gain in prices more than offset lower production. The rise
in prices has far exceeded the cuts in production. For example, Saudi oil output
has fallen by 6% since last October, while prices have risen by 22%. If current
prices and production were to be sustained for the whole year, Saudi oil revenues
would be higher by around $27bn compared to what would have happened without
the deal.

4. But higher oil
prices may not be sustained as US shale oil could make a comeback. Higher oil prices
are making US shale oil profitable again. US production
rose in December after several months of continuous decline. The International
Energy Agency is reporting increased investment in US
shale oil, implying more supply to come in 2017. Higher US supply would
lead to lower prices, reversing the gains made by OPEC cuts.

In conclusion, OPEC
successful implementation of production cuts has pushed prices higher and
benefited the revenues of its members. But the strategy could be self-defeating
as it is giving US shale oil producers a lifeline to increase their production
and depress prices again. If this does happen, then OPEC would either be required
to support prices by making further cuts or make a U-turn on its strategy.

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About Me (Ziad Daoud)

I am an economist currently based in the Middle East. I have previously worked for an asset management firm and, before that, I did a PhD at the London School of Economics. The views in this blog are solely my own.